You can lose money even if you trade your bond for one with a higher return; understand – 06/25/2023 – From Grain to Grain

Redeeming an application that yields less, in search of another that yields more, may not compensate because of the IR rate. Most investors disregard the tax issue, as they only look at the gross income tax return and end up having less, even investing in securities that apparently yield more.

I’ll explain with an example, but first I’ll apply a test.

Consider that you invested in a fixed income security and intend to use the money in 2 years (722 days). When you invested a year ago, the interest rate was lower. Suppose you invested in a bond with a fixed return of 10% per year.

At the moment, this title loses the CDI, as it is at 13.65% per annum. So your title looks pretty bad right now. Yields only 73.26% of the current CDI.

However, we know that the CDI is going to fall and the market is already pricing that in the next 12 months, it should return only 12% per year. Which of the two alternatives would you do now:
a) maintain the current security with a return of 10% per year for another year, completing 721 days or two years of investment;
b) redeem the current bond and invest for 361 days in the fixed rate bond yielding 12% per annum.

Most investors tend to opt for alternative “b”. The preference is not for nothing.

Even compared to the expected CDI for the next 12 months, its current bond with 10% per year returns 2% lower, that is, 83.3% of the expected CDI.

Switching to the highest yielding title seems like the only alternative that makes sense.

Now is the time, that you might call me crazy. However, the best alternative is to keep the current title yielding only 10% per year. I’m gonna explain.

The problem here is that only gross IR income was considered. In the evaluation, it is always necessary to evaluate the net income tax return.

For this, the first step is to know the IR rates. I’m going to talk today only about fixed income.

The income tax rate for this asset class is regressive and falls over time. The table below shows the IR rate for each term.

Term	income tax rate
up to 180 days	22.50%
from 181 to 360 days	20%
from 361 to 720 days	17.50%
over 720 days	15%

Follow the calculation to understand the comparison.

If you applied 361 days ago, your income tax rate is 17.5% on earnings. If you invested BRL 10,000, you had a return of 10% in one year, therefore, BRL 1,000. Therefore, your investment adds up to R$ 11 thousand. However, if you redeem it now, you will only have R$10,825.00 available to reinvest.

If you choose alternative “a”, you will keep the title for another 361 days and, with the yield of another 10%, you will end the period with a total value of R$ 12,100.00. With the maturity of the bond after a total of 722 days, you will be subject to the 15% income tax rate on earnings. This means that the net amount available to you is BRL 11,935.00.

Now let’s evaluate alternative “b”. You redeemed the security now, after the first year has passed and you have R$ 10,825.00 available to reinvest. You can reinvest with a return of 12% per year for another 361 days. This application will have a nominal income of R$ 1,299.00. However, after the 361 days have passed and it expires, you will again be subject to the rate of 17.5% per annum. Therefore, the amount of R$ 11,896.68 will be net.

This means that redeeming and exchanging will generate, at the end of the 722-day period, a value of BRL 38.32 less than the decision to keep the original title.

This was an illustrative example, but an important one to call your attention to the fact that any exchange must be much more analyzed than most realize. Therefore, be careful when changing securities, seeking a higher return and without looking at the net return on income tax.

The shorter the term you keep the bond, the more important it is to assess the net income tax return. Remember, what’s worth is the money left in your pocket, net of all expenses.

Michael Viriato is an investment advisor and founding partner of Investor House.

Talk directly to me via email.

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